Wednesday, March 5, 2008

Problems of UK Economy no.1 - Inflation

Over the next few days I am going to start a series looking at the various economic problems facing the UK economy. Many of these problems are equally relevant for other economies such as the US. The first problem I have chosen is inflation.

Is Inflation a Problem for UK

Current CPI inflation is 2.3%. The government's target is 2% +/- 1

The MPC recently warned that by the end of 2008, 3% inflation would be likely if they cut interest rates to 4.5%. Most of the current inflationary pressures are cost push, and are related to the rising price of wheat, oil and other commodities.But, to be honest, inflation of 3% is hardly a major problem - especially if the inflation 'spike' proves temporary. It's rather ironic that these days we get worked up about inflation potentially rising to 3%. By historical standards, 3% is quite low for the UK. Even at 3% many of these costs of inflation are quite limited. However, the MPC might argue that if inflation does rise to 3%, it may become more difficult to keep it low in the future and rising inflation is something people become to expect. In other words, we should worry about a change in expectations of inflation.

A Return to Stagflation?

The real difficulty comes if, the UK enters a serious economic downturn or recession, and inflationary pressures continue to worsen. This is an experience known as stagflation and present policy makers with an unenviable dilemma - Increase interest rates to keep inflation down, but worsen the recession; or cut rates to stimulate demand and make inflation worse.

Inflation combined with lower growth is a real problem. My main concern is that the MPC is so fixated on reaching the government's inflation target that they may ignore other macroeconomic objectives. My feeling is that the MPC are likely to keep interest rates high, even if it causes an unnecessary downturn.

Does Inflation Measure the Cost of Living Any more?

A different issue regarding inflation is whether CPI accurately reflects the cost of living. Many argue UK CPI inflation rate is no longer an accurate reflection of people's living standards. Ask a variety of people about the cost of living in the UK and most would scoff at the idea of 2% inflation. For example:

pensioners see their council tax bills rising 100% in the past few year (see this blog post)

Due to rising house prices, young first time buyers are inundated with large mortgage payments or expensive rents.

There is also inequality with regard to inflation. Low income groups often spend a higher % of income on food, heating and transport. It is these items which are seeing above inflationary growth. Therefore, many people living on index linked benefits are seeing a decline in their living standards.

This graph shows an increasing divergence between CPI inflation (official method and old measure of RPI.

If you buy electronic goods and cheap clothing imports then your cost of living is probably accurately reflected by the CPI. But, some low income groups are suffering from having benefits linked to CPI inflation when their cost of living is rising at a faster rate.